The 3 Types of Financial Statements

Balance Sheet, Income Sheet, and Cash Flow Statement

Sales are up, cash is rolling in, and business is growing—high five! If you’re a business owner, there’s one thing you absolutely cannot and should not skip: accurate financial statements.

Financial statements are the foundation of corporate accounting. As a matter of fact, in Canada, businesses are required to prepare and present financial statements that give a clear picture of their financial health. Financial statements are often audited by government agencies and accountants to ensure your business is accurately reporting on taxes and the financial health of your company.

What Are Financial Statements?

Financial statements are formal records of the financial activities and position of a business, person, or other entity. In Canada, these statements are essential not only for regulatory compliance but also for making informed business decisions.

While there are many types of statements, sheets, and forms you’ll come across as a business owner, there are 3 key types you should know about: the Balance Sheet, the Income Statement, and the Cash Flow Statement. Each of these statements provides unique insights into different aspects of a company’s financial performance and position. Together, they offer a comprehensive view that helps business owners and stakeholders make informed decisions.

The Balance Sheet: A Snapshot of Financial Position

The Balance Sheet provides a snapshot of a company’s financial condition at any specific point in time. It’s structured around the accounting equation: Assets = Liabilities + Shareholder/Owner Equity. This equation must always balance, hence the name “Balance Sheet.”

Key Components of the Balance Sheet

1. Assets: These are resources owned by the company that are expected to bring future economic benefits. Assets are typically divided into short-term, or current, and long-term, or non-current. Short-term assets, which can be converted into cash within 1 year, usually include cash & cash equivalents, marketable securities, accounts receivable, inventory, and prepaid expenses. Long-term assets, which cannot be converted into cash within 1 year, include long-term investments, fixed assets (land, machinery, buildings, etc.), and intangible assets (intellectual property, goodwill, etc.).
2. Liabilities: These are obligations that the company must settle in the future. Like assets, liabilities are classified as current (to be settled within a year) and non-current (to be settled after a year). Current liabilities may include debt due within 12 months, interest payable, wages payable, dividends payable, and accounts payable. Non-current liabilities may include long-term debt, pension fund liability, and deferred tax liability.
3. Shareholder/Owner Equity: This represents the amount of money that belongs to you, as the owner, within your company. If the company has shareholders, it also refers to the funds held by other shareholders. It includes items like common stock, retained earnings, and other comprehensive income.

Importance of the Balance Sheet

The Balance Sheet is crucial for understanding a company’s financial health. Investors and creditors use it to assess the liquidity, solvency, and capital structure of a business. For example, a high level of current assets compared to current liabilities suggests good liquidity, meaning the company can cover its short-term obligations.

The Income Statement: Measuring Financial Performance

1. Revenue: This is typically divided into 2 sections: operating revenue and non-operating revenue. Operating revenue is the income generated from normal business operations, typically from the sale of goods and services. Non-operating revenue is earned from non-business activities, such as interest earned on cash in the bank, rental income, and income from an advertisement display located on company property.
2. Expenses: These are the costs incurred in earning the revenue. Expenses can be categorized into operating expenses (such as salaries and rent) and non-operating expenses (such as interest and taxes).
3. Net Income: This is the profit or loss after all revenues and expenses have been accounted for. A positive net income indicates profitability, while a negative net income indicates a loss.

Importance of the Income Statement

The Income Statement is essential for evaluating a company’s profitability and operational efficiency. It helps stakeholders decipher how well the company is managing its resources and whether it is generating sufficient returns. For investors, consistent profitability is a key indicator of a company’s potential for growth and stability.

The Cash Flow Statement: Tracking Cash Movement

The Cash Flow Statement provides a detailed analysis of how cash flows in and out of a company over a specific period of time. It is divided into 3 sections: operating activities, investing activities, and financing activities.

Key Components of the Cash Flow Statement

1. Operating Activities: This section shows the cash generated or used by a company’s core business operations. It includes cash receipts from sales, cash payments for goods and services, accounts payable, wages, and income tax.
2. Investing Activities: This section reflects the cash flows related to the acquisition and disposal of long-term assets and investments. For example, cash spent on purchasing new equipment, payments related to a merger or acquisition, and loans made to vendors would be included here.
3. Financing Activities: This section shows the cash flows associated with a company’s financing activities, such as issuing shares, borrowing, and repaying debt.

Importance of the Cash Flow Statement

The Cash Flow Statement is vital for assessing a company’s liquidity and financial flexibility. It reveals how well the company manages its cash to fund operations, invest in growth, and meet financial obligations. For example, a positive cash flow from operating activities indicates that the company generates enough cash to maintain and expand its operations.

How the 3 Financial Statements Are Interconnected

Understanding the interrelationship between the Balance Sheet, Income Statement, and Cash Flow Statement is crucial for a comprehensive analysis of a company’s financial health and any potential issues that may need to be addressed in the short or long term.

There are 3 main ways these financial statements are interconnected:

1. Net Income from the Income Statement: This figure flows into the Equity section of the Balance Sheet under retained earnings. It also serves as the starting point for the Cash Flow from Operating Activities section in the Cash Flow Statement.
2. Changes in Balance Sheet Accounts: These changes are reflected in the Cash Flow Statement. For instance, an increase in accounts receivable would appear as a decrease in cash flow from operating activities.
3. Cash at the End of the Period: This figure from the Cash Flow Statement must match the cash balance reported on the Balance Sheet at the end of the period.

By understanding these connections, stakeholders can see how transactions affect different aspects of a company’s financial situation.

Financial statements are indispensable tools for anyone involved in business or finance. They provide essential insights into a company’s financial position, performance, and cash flow. By examining these statements, stakeholders can make informed decisions, evaluate financial health, and plan for the future. Whether you are a business owner, investor, or financial analyst, mastering the art of reading and interpreting financial statements is crucial for success.

Financial statements may seem complex at first, but with a bit of practice and understanding, they become invaluable resources for making informed financial decisions for your business. Need some assistance with your financial statements and reporting? Give us a call at 416-646-0550 or request a consultation to get started with our expert team.